ledgerOur blog recently discussed how soft dollar arrangements can impact the bottom line for both advisers and investors, and therefore require adequate disclosure. Other compliance requirements involve non-client facing operations, but are equally important to monitoring and protecting against conflicts of interest. The Personal Trading Policy is one such requirement.

The Investment Advisers Act and the Code of Ethics rules adopted thereunder mandate that advisers have a personal trading policy to protect against misuse of material non-public information, such as timing trades to disadvantage clients, or the market itself- both breaches of fiduciary duty. The rule requires employees with access to such information to report personal securities holdings and transactions for the adviser to maintain and periodically review.

The Adviser must, first, determine which employees are “access persons”. Generally, an employee will be an “access person” if that person: a) has access to nonpublic information regarding clients’ transactions or portfolio holdings, and/or b) makes, or has access to, securities recommendations to clients. This includes not only those making the recommendations or accessing client information, but their supervisors, and company partners, officers and directors as well.

Advisers should be requesting access persons to report holdings within 10 days of assuming an “access” role, and seeking annually certification of holdings and interests (these may include others in their household). The Adviser’s Code should also require access persons to report personal trading of reportable securities on a quarterly basis, thereafter. Finally, Adviser’s are obligated to keep adequate books and records to show compliance with these requirements, and efforts to monitor trading. Many access persons meet reporting requirements by having duplicate trading statements sent directly to the adviser, while other firms require that employee trading accounts be held by an affiliate of the firm (where existing). Careful manual or automated surveillance will look for both trading in securities in common with clients, or impacted thereby (ie. options trades), or other peculiar transactions that precede market movements.

There are also classes of securities, such as money market funds or government securities, which represent a low risk for trading abuses and, therefore, are exempted from the reporting requirement. Though the Code must also require pre-clearance for access persons to participate in IPOs or certain private offerings, many firms have broader restrictions.

In our next blog post installment, we will be exploring the topic of proprietary trading.

IcebergIn our last post, Craig began our discussion of trading practices by examining an adviser’s duty to obtain best execution. This post continues our trading practice discussion with a focus on soft dollar arrangements.

Soft dollar arrangements generally arise when an adviser receives research or brokerage products or services from a broker-dealer in exchange for placing securities transactions with that broker-dealer. Soft dollars arrangements can potentially provide significant benefits to your firm’s clients by generating access to a greater variety of investment research or services than would otherwise be available without them.

So, what’s the potential issue? In order to receive the research or services, your firm may pay more than the lowest possible commission rate to a broker-dealer. If it does so, because the research and brokerage services are provided in exchange for client commission dollars (i.e., soft dollars), which are client assets, your firm could be viewed as breaching its fiduciary duty to its clients by using client assets to pay for products or services that should be paid for by your firm directly.

While the potential for conflict is inherent in utilizing soft dollar arrangements, your firm does not have to avoid them as a general prohibition. Section 28(e) of the Securities Exchange Act of 1934 provides a safe harbor for advisers that enter into soft dollar arrangements, provided certain conditions of the safe harbor are satisfied. In other words, by adhering to the conditions contained in Section 28(e), your firm will not have breached its fiduciary duties under state or federal law solely because it paid a brokerage commission to a broker-dealer for effecting securities transactions in excess of the amount another broker-dealer would have charged.

Generally, a particular product or service falls within the safe harbor if an adviser can demonstrate that the research or brokerage service obtained with soft dollars: (i) is an eligible research or brokerage service within the specific limits of the safe harbor, (ii) provides lawful and appropriate assistance in the performance of an adviser’s investment decision-making responsibilities, including the appropriate treatment of “mixed-use” items (i.e., certain products and services may have mixed use and could be allocated between hard and soft dollars depending on the way in which the adviser uses the products or services), and (iii) the amount of client commissions paid is reasonable in light of the value of the products or services provided by the broker-dealer.

It’s important to note that while the three prongs listed above comprise the conditions of the safe harbor in its entirety, each prong requires additional individual analysis and application to the particular arrangement proposed. As stated above, soft dollar arrangements have the potential to provide significant benefits to your clients. However, you should enter them with care, consulting with a compliance professional as necessary, so that you can be sure that any proposed arrangement is not likely to violate your firm’s fiduciary obligations. If you have any questions about your firm’s soft dollar arrangements, please don’t hesitate to reach out to us.

Check back in next post, when our colleague Marc Minor debuts on the blog with his discussion of a firm’s duties with respect to the personal trading activities of its supervised persons. Thank you for your continued support!

So, let’s say your robo-adviser firm has created a brand new strategy that you think would be attractive to investors.  You’ve registered your firm, licensed your personnel, built and tested the algorithm, and now you’re ready to bring your strategy to market.  Now, all you need to do is find a broker who can help buy and sell the securities your algorithm recommends.  Does it matter who you pick?  You bet it does.

All investment advisers owe a fiduciary duty to clients to seek “best execution” of their securities transactions.  The SEC has described this requirement generally as a duty to execute securities transactions so that a client’s total costs or proceeds in each transaction are the most favorable under the circumstances.  To fulfill this duty, an adviser should consider the full range and quality of a broker-dealer’s services in placing trades. Critically, the SEC has explained that best execution is not determined by the lowest possible commission costs, but by the best qualitative execution.  Otherwise stated, you needn’t necessarily pick the cheapest firm – instead, you’re looking for the best value.

So what does this mean practically?  It means that before you pick a broker to execute client trades, you will need to determine (and document) how that broker will fulfill your best execution obligation.  You should consider a number of quantitative and qualitative factors in selecting a broker, such as execution capability, commission rates, financial responsibility, confidentiality, frequency and correction of trading errors, expertise in specific securities, credit quality, the value of research provided, and responsiveness to your firm.

Moreover, best execution is not a once-and-done thing.  The SEC expects advisers to periodically and systematically evaluate the performance of brokers executing client transactions.  As a result, over time, you may have to consider whether a change in broker is warranted.

Worried about how to get this all done and documented?  Just create and implement best execution policies and procedures and train your personnel on how they work.  Such policies and procedures should contain guidelines and factors used to select brokers, formalize the frequency and process for ongoing evaluations, appoint specific individuals or teams responsible for action items, and require documentation of steps taken.

However, that’s not the end of the story when it comes to brokerage practices.  Part and parcel of the best execution obligation is understanding and addressing conflicts created when a broker provides your firm with research products and services under what is commonly known as a “soft dollar” arrangement.  We hope you’ll return for our next post, when Josh will explain how such arrangements work and how to use them effectively.

portfolioIn a previous blog post, we discussed an adviser’s fiduciary duty to provide advice based on the client’s financial situation and investment objectives. In today’s post, we’ll examine the practical implications of this requirement from a compliance prospective.

Craig noted in our last entry that Advisers Act Rule 206(4)-7 (the “Compliance Rule”) requires that every investment adviser adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules. The adopting release for the Compliance Rule includes a list of the critical compliance policies that the SEC expects each adviser to address. The first of these critical policies relates to an adviser’s portfolio management processes.

The most important consideration in developing your portfolio management compliance policy is developing procedures that ensure adherence to the investment profile of each of your clients, including each client’s investment objective, restrictions, and risk tolerance. Moreover, your firm must address how your firm allocates investment opportunities among its clients.

As a robo-advisory firm, you likely have little to no in-person contact with your clients and your firm also likely utilizes a proprietary algorithm for portfolio selection. Given this scenario, your portfolio management compliance policy should focus on:

  1. ensuring that your client intake process is adequately designed to capture each client’s investment profile, including the client’s investment objective and risk tolerance (see our fiduciary duty post on this topic above for more information on this process);
  2. that investment opportunities are allocated equitably among all clients (this not typically an issue for robo-advisory firms given the general availability of offerings, e.g., ETFs, mutual funds, etc.), and
  3. developing procedures for a periodic review of your algorithm to ensure that its security selections remain consistent with each client’s investment profile, as well as any applicable regulatory disclosures or restrictions, especially in light of any relevant market or profile changes that may have incurred since the client’s initial intake.

At minimum, your portfolio management compliance policy should clearly articulate your understanding of the duty to only select securities that are suitable for each client’s specific investment needs, which is accompanied by procedures that detail a regular review and documentation of your investment methodology to ensure compliance with your policy. A best practice would be to conduct periodic sampling tests on the results produced by your algorithm to ensure that they are consistent with each client’s investment profile.

It’s important to note that the compliance procedures designed for any policies related to your portfolio management process need not be rigid. Instead, consider designing your policies and procedures in a manner that allows for necessary flexibility. Market conditions are ever changing. Designing a policy that mandates a yearly review of your algorithm to ensure that it is producing portfolios consistent with client expectations may be adequate in periods of less volatility.  However, in a less stable market environment a more frequent review process to ensure consistency may be required. Your compliance policy should account for such a contingency.

We hope you’re finding our examination of critical compliance policies helpful. Please don’t hesitate to reach out if you have any questions. We continue with this topic series in our next post when Craig discusses trading practices. As always, we thank you for your continued readership!

To date, we have covered a myriad of topics designed to help you get your firm off the ground, focusing primarily on issues like registration, licensing, advertising, disclosure, and communicating and contracting with clients.  These critical issues have one thing in common – they all involve working with folks outside your firm. Today, we kick off a new chapter of our blog, inviting you to turn your gaze inward and examine the key pieces of your compliance program.

So, let’s start at the very beginning. Advisers Act Rule 206(4)-7 (the “Compliance Rule”) requires that all advisers registered with the SEC:

  • adopt and implement written policies and procedures reasonably designed to prevent the adviser and its personnel from violating the Advisers Act and rules adopted under the act;
  • review, at least annually, the adequacy of those policies and procedures and the effectiveness of their implementation; and
  • designate a chief compliance officer to administer its compliance program.

Interestingly, the Compliance Rule doesn’t indicate what operational issues those policies and procedures should cover.  To find out, we need to look at the Compliance Rule’s adopting release.  In that release, the SEC stated its expectation that an adviser’s policies and procedures, at a minimum, address the following areas to the extent they are relevant to the adviser:

  • Portfolio management processes
  • Trading practices
  • Proprietary trading of the adviser and personal trading activities of supervised persons
  • The accuracy of disclosures made to investors, clients and regulators
  • Safeguarding of client assets from conversion or inappropriate use by advisory personnel
  • Recordkeeping
  • Marketing of advisory services
  • Valuation and fee assessment
  • Privacy and information security
  • Business continuity

Granted, depending on the particularities of an adviser’s business, a firm is likely to need policies and procedures that cover additional compliance areas.  Nevertheless, the list above serves as a good baseline to start from when building or initially assessing your program.  As such, our next series of blog posts will walk you through these key compliance areas so that you can meet your regulatory obligations effectively and efficiently.   We hope you’ll return for our next post, when Josh will discuss critical aspects of your portfolio management processes, including policies and procedures for maintaining the algorithm driving your investment decisions.

Business Continuity PlanTo our readers, we hope this entry to our blog finds you and your family safe and healthy. As we all begin to envision a path forward following the unprecedented events caused by the COVID-19 pandemic, a focus on compliance for your firm should not be an overlooked task.

For robo-advisers, this is an opportunity to analyze your compliance program with specific attention on policies that may have been trigged as a result of the pandemic. Given the need for social distancing and the stay-at-home restrictions imposed by many states, it is likely that your firm operated at some point, and perhaps for the entirety, of the past few months pursuant to its business continuity plan (“BCP”).

Barring some unexpected previous need, this is likely the first time that your firm had to rely on its BCP. Like all compliance polices, periodic review and testing for effectiveness is always a best practice. In essence, the last few months have served as a live test of your BCP. What makes a review of your BCP so important at this juncture is that it presents an obvious target for potential regulatory review. During your next examination, your firm should anticipate scrutiny by the SEC staff of any compliance policy likely to have been relied upon during the pandemic. In preparation for such an exam, it would be prudent to evaluate your BCP as presently drafted and compare it against the practicalities of how your business operated for the past few months while the plan was in effect. Identify and reconcile any divergences from the plan. That is, analyze how your business operated during this period and ensure that the policy and procedures laid out in your compliance program accurately and appropriately match those business operations. Additionally, your firm should also work to identify any potential gaps in your BCP. Even if your firm operated in line with its current policy, consider if there were any lessons or best practices that could be adopted to improve your compliance procedures.

Staying ahead of regulatory scrutiny involves anticipating issues before they become problems. Regular review and testing of a compliance program are critical to the success of all robo-advisory firms. If we can be of assistance in reviewing your BCP or any aspect of your compliance program, please don’t hesitate to reach out. We thank you, as always, for your continued support of the blog and hope you’ll check back soon for our next entry.

If you can believe it, May 1, 2020 is almost upon us.  And if you don’t remember from our February post, that is the day when advisory firms serving retail investors may start filing client relationship summaries on Form CRS.  As a reminder, Form CRS gives clients a quick summary of the key things they need to know about working with your firm, as it discusses types of services offered, fees charged, conflicts of interest, and disciplinary history.  While it cannot exceed two pages, Form CRS still manages to cover many of the same topics that are discussed in detail in Form ADV Parts 1 and 2.

On April 7, 2020, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a risk alert announcing that regulatory exams occurring after the compliance date for Form CRS (June 30, 2020) will assess how well firms have implemented policies and procedures to ensure compliance with the new requirements. In that alert, OCIE confirmed that examinations of advisers occurring after the compliance date will:

  • assess whether firms have filed, delivered and posted Form CRS as required;
  • determine whether the content and format requirements of Form CRS have been met; and
  • evaluate whether Form CRS recordkeeping processes have been implemented.

Importantly, in the risk alert, OCIE discussed with some particularity how the staff anticipated assessing compliance with Form CRS.  OCIE noted specific questions the staff may ask, what documents may be requested, and what disclosures the staff might expect to see.  For example, the staff may review records of the dates that Form CRS was delivered, advisory contracts to confirm consistency with disclosed fees, or copies of the adviser’s recordkeeping policies and procedures.  Firms tasked with compliance with Form CRS should review the guidance provided in the risk alert and evaluate whether any updates to their compliance program should be made.

We will continue to follow guidance released by the staff on Form CRS and keep you informed.  And please be sure to check back next time, when Josh will discuss a challenge you’re probably facing right now – ensuring that your business continuity plan is effective or gets the upgrades it needs so that you can continue to operate in this time of adversity.  Until then, we hope you are staying safe and healthy.

As Josh discussed earlier this week, the annual update to Form ADV is generally due at the end of March for most robo-advisers.  However, we are interrupting our current discussion thread to make sure you were aware that on March 13, 2020, the SEC extended Form ADV filing and delivery deadlines for investment advisers whose operations may be affected by the coronavirus.  The agency acknowledged that the impacts of the pandemic may delay or prevent advisers operating in affected areas from meeting certain regulatory obligations due to restrictions on travel, access to facilities, the potential limited availability of personnel and similar disruptions.

To enable advisers to meet those obligations and to continue their operations, while recognizing that there may be temporary disruptions outside of their control, the SEC issued an order (“Order”), effective through April 30, 2020, exempting advisers from the requirements to (i) file an amendment to Form ADV and (ii) deliver amended brochures, brochure supplements or summaries of material changes to clients.

The exemptions are available provided that the firm:

  • is not able to meet a filing deadline or delivery requirement due to circumstances related to the coronavirus;
  • promptly notifies the SEC via email and the public via its website that it’s relying on the Order, why it’s relying on the Order and when it expects to be able to meet the filing or delivery deadline; and
  • meets the filing or delivery deadline by no later than 45 days after the original due date.

Please don’t hesitate to reach out to us with questions on how the Order may affect your firm.  We will continue to monitor regulatory events related to coronavirus and keep you updated.   And be sure to check back soon, as we plan to return to our regularly scheduled discussion topic – how to ensure that your algorithm continues to work for clients the way that you intend.

equationWith the deadline for the annual update to Form ADV closing in at the end of March, let’s examine one aspect of Form ADV disclosure which impacts a majority, if not all, robo-advisory firms – algorithm related disclosure.

Your firm likely utilizes a proprietary algorithm to automatically determine client asset allocation among a limited set of investment products. Typically, this is done after a client has provided certain personal information (e.g., personal income, risk tolerance) through an intake questionnaire. While this process is an effective and efficient business model for both your firm and the client, it is critical that you fulfill your fiduciary and regulatory obligations.

One of your primary fiduciary and regulatory obligations is disclosure. As we previously discussed, your firm must register, either federally or with any applicable state, by completing and submitting Form ADV. General Instruction 3 of Part 2 of Form ADV requires you to disclose your obligations as a fiduciary, including all material facts relating to your advisory relationship with your clients and any potential conflicts. For a robo‑adviser this consists of disclosure regarding your algorithm, including, at a minimum:

  • A general statement that an algorithm is used to manage client accounts;
  • A description of how the algorithm is used (e.g., that client accounts are initially invested and periodically rebalanced, if applicable, by algorithm);
  • An explanation of the underlying methodology of the algorithm; and
  • Any involvement by a third-party in the design, maintenance, or ownership of the algorithm (e.g., if the algorithm directs client assets to third-party investment products for which the third party earns a fee).

While much of this disclosure is straightforward, publicly disseminating the underlying methodology of your algorithm presents a potential issue – you don’t want to give away proprietary trade secrets. However, you can meet your fiduciary duty and protect the proprietary nature of your algorithm design at the same time. In describing the methodology of your algorithm, focus on its assumptions and limitations. For example, if the algorithm is based on modern portfolio theory, a description of the assumptions and limitations of that theory would adequately fulfill your fiduciary obligations without disclosing the particulars of investment selection.

Moreover, focus your algorithm disclosure on potential risks, such as any instances when the algorithm may rebalance a client’s account without regard to market conditions. Also consider disclosing any level of human involvement in the management of the algorithm, for instance if there are dedicated personnel overseeing the algorithm but not monitoring individual client accounts.

When preparing your ADV updates this year, take an extra moment to review your algorithm disclosure. And don’t hesitate to reach out if you have any questions.

As always, we thank you for your continued readership. Please check back next time when Craig will discuss tips for making sure, on an ongoing basis, that your algorithm continues to serve your clients the way you intend it to.

OK, so remember last June when we discussed registering your firm? If you do, you may recall that the principal adviser registration document, Form ADV, is divided into two parts: Part 1 (a check-the-box form that is mostly for use by the regulator) and Part 2 (a narrative brochure that is the principal client disclosure document).

Well, for advisers registered with the SEC, as many robo-advisers are, there will soon be a new disclosure document to contend with. New Form CRS (client relationship summary) is designed to give investors easily digestible information about their relationship with their investment adviser. The form, which may not exceed two pages, provides information such as types of services offered, fees charged, conflicts of interest, and disciplinary history, covering many of the same topics that are discussed in detail in Form ADV Parts 1 and 2. Form CRS also includes sample questions or “conversation starters,” which clients can use to get additional information directly from their financial representatives.

Importantly, Form CRS is required only for advisers whose clients are “retail investors,” meaning natural persons seeking services primarily for personal or family purposes. This means that investment advisers that don’t serve retail investors need not worry about Form CRS. That said, because most robo-advisers have retail investor clients, most robo-advisers will need to complete, file and deliver the form.

When does this all start, you ask? Advisers currently registered with the SEC will need to file their initial Form CRS through IARD between May 1 and June 30 of this year. Importantly, you may not file the form prior to May 1, 2020. This means that for an adviser with a calendar fiscal-year end, the initial Form CRS must be filed as an other-than-annual amendment; it cannot be filed as part of the adviser’s annual Form ADV update due March 30, 2020.

Once you’ve filed Form CRS, you’ll need to start delivering the initial Form CRS no later than June 30, 2020 for new clients and July 30, 2020 for current clients. In addition, if any information in your Form CRS becomes materially inaccurate, you’ll need to file an amendment within 30 days and notify clients within 90 days.   Unlike Form ADV Parts 1 and 2, Form CRS does not have an annual filing requirement. Instead, once you’ve filed the form, you just need to make sure it stays accurate and notify clients if anything changes.

Speaking of notifying clients, let’s talk about how to actually deliver Form CRS. As a robo-adviser, chances are you will send Form CRS electronically. When you do, be sure to follow the form’s instructions, which require that the relationship summary be (i) presented prominently in the electronic medium, like a direct link or in the body of an email or message, and (ii) easily accessible. And of course, don’t forget to implement the tips we shared in our previous post on electronic communications.

Finally, just a brief word on recordkeeping. When they adopted Form CRS, the SEC also adopted corresponding amendments to Advisers Act Rule 204-2 (the recordkeeping rule). Those amendments, broadly speaking, require advisers to keep current and historical copies of Form CRS (including amendments) and records of the dates that the form is filed and delivered to clients.

Even though Form CRS need not be filed until June, we still recommend that advisers with retail investor clients take the time now to:

  • draft and finalize the initial Form CRS, consulting with counsel as necessary;
  • develop and update policies and procedures to ensure that on an ongoing basis, Form CRS is filed, delivered and updated appropriately; and
  • update recordkeeping portions of their compliance manual as needed to account for Form CRS.

That’s all for this time! Be sure to come back for our next post, where Josh will kick off a new chapter of our blog focused on compliance concerns related to the heart of your business – portfolio management and trading.